Last week, we published a white paper that focuses on income replacement ratios (IRRs), health care inflation rates, and strategies to bridge the savings gap caused by unplanned retirement health care costs.
Today, I will highlight some of the paper’s major points.
First, readers must understand that financial advisors use IRRs – a percentage of an individual’s pre-retirement income – to project the amount of annual income a person will need to fund his/her retirement. The general rate for IRR calculations is usually between 75-85%, but over the past several years, 80% has evolved to become the favored industry standard.
Our current research indicates that because of rising health care costs, this calculation may be inherently flawed.
First, IRRs only factor a portion of medical expenditures into their retirement income projections. Private health insurance plans, such as HMOs and PPOs, require individuals to cover 25% of their insurance premiums, while employees subsidize the remaining 75%. IRRs use the standard 25% in their retirement health care cost projections, but Medicare, the health insurance plan for those aged 65 and older, requires beneficiaries to cover 100% of their medical expenses through premiums, supplemental plans, and out-of-pocket costs. This disparity will result in a significant health care savings gap for many retirees.
Additionally, IRRs assume health care costs will inflate at the general rate of 2-3%. Our latest data forecasts health care to increase between 6-7% annually. This differential, compounded over time, will widen the gap between what individuals have saved and what health care will actually cost in retirement.
Lastly, Medicare means testing, which will impact millions of retirees over the next two decades, is not factored into income replacement ratios. Individuals who earn over $85,000 per year, or couples who earn over $170,000 per year, will see their Medicare premiums rise from 37% to over 200%. This variable is not factored in current IRR calculations.
Ultimately, the percentage of savings that Americans currently dedicate to address retirement health care expenditures is going to fall far short of the actual outlay. The paper examines this issue in two comprehensive case studies, which are briefly discussed below.
A 45-year-old earning $50,000 per year (with an annual 3% increase) using a standard 80% IRR allocates $2,933 annually to his 401(k) for future medical expenses. Because pre-retirement health care costs are not directly comparable to those in retirement, this person is actually underfunding his 401(k) by $3,460. With no additional investments, this deficit will escalate to $127,299 by age 64. The good news is that if he takes action now, a modest $90 increase in 401(k) contributions per pay period (assuming 26 pay periods and a 50% employee match) will eliminate this deficit.
In the second case study, a 55-year-old retiring at age 65 without an IRR-based savings plan would need a lump-sum investment of $81,328 to cover the projected $388,870 needed for retirement health care costs. Using an IRR-based plan will drop the number to $25,679. Now, a much more manageable annual investment of $3,291, (or $274 per month) over ten years at a 6% return would close this gap.
While current IRRs may underestimate the income necessary for a stable retirement, they at least provide participants with a foundation of savings – as compared to individuals who do not participate in an IRR-based plan – and additional product solutions are available.
Consulting a knowledgeable advisor who implements the right investment mix, including 401(k)/Roth 401(k), non-qualified annuities, and life insurance policies is an important step in addressing the high cost of health care in retirement and attaining long-term financial security.